Act Two in the unfolding Eurozone drama begins this week as leaders at the European summit announce emergency measures to prevent further market turmoil. Why the sudden urgency? Because the German Bundesbank is about to exhaust its capacity to lend more funds to strapped governments.

In the wake of the 2008 crisis, some national central banks, especially those in Greece, Ireland, Italy, Portugal, and Spain (the GIIPS), have dramatically increased their loans to financial institutions. To fund these loans, GIIPS central banks borrowed mainly – via the ECB – from other central banks, in particular the Bundesbank. In order to fund these loans, the Bundesbank sold its holdings of German assets. Asshown in Figure 1, between December 2007 and September 2011 the central banks of the GIIPS increased their loans to domestic financial institutions by nearly €300 billion. In contrast, the stock of gross German assets in the Bundesbank balance sheet fell sharply to its lowest level in history.

The ominous sign – which might set the stage for Act Two in the unfolding Eurozone drama – is the fact that the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem. At that point, the Bundesbank could sell its gold or increase the deposits it takes from the private sector. Most likely, however, the Bundesbank will face strong pressure from the German public against such action. Hence, it appears as if the Eurozone crisis is entering a second phase in which policymakers feel the need for new measures to prevent market turmoil.

Figure 1. Domestic lending of central banks in the Eurozone

Source: IFS and Bundesbank, Monthly Bulletins.

Note: Domestic lending of the central bank is the sum of claims on other depository corporations, net claims on the government and claims on other sectors.

In order to further analyse the dynamics within the Eurozone monetary system, consider the typical balance sheet of a central bank. As shown in Table 1, the assets include gold and international reserves. Second, they include government bonds and private securities, as well as other assets that the central banks can buy and sell in the open market. Less well known, but quantitatively very important, are the claims of a central bank on the Eurosystem – the ‘TARGET’ claims. These TARGET claims arise when an international purchase of goods or assets is not immediately offset by a private financial flow. Next, the liabilities of a central bank include the currency in circulation, the deposits it takes from financial institutions, and the TARGET liabilities with the Eurosystem. To avoid confusion, we would like to clarify that the size of the balance sheet of a central bank – also known as the ‘monetary base’ – is not equal to the money supply.

Table 1. The balance sheet of a central bank

Assets

Liabilities

Gold and reserves

Bills in circulation

Private securities owned by central bank

Deposits from private credit institutions

Public securities owned by central bank

Loans from Eurosystem (TARGET liabilities)

Other assets

Other liabitlies

Loans to Eurosystem (TARGET claims)

Capital

As we can see in Figure 2, the drastic decline in securities held by the Bundesbank tracks closely the sharp increase in loans from the Bundesbank to the Eurosystem: the securities of the Bundesbank declined from €268 billion in December 2007 to €21 billion in October 2011. Meanwhile, the loans to the Eurosystem increased by nearly €400 billion. The latter number is larger because the Bundesbank also borrowed in the private capital market – by taking deposits – as shown in Figure 3 further below.

Figure 2. Assets of the Bundesbank

Source: Bundesbank, Monthly Bulletins.

In principle, the limit on the amount of claims on the Eurosystem that the Bundesbank can accumulate equals the assets in its balance sheet plus the amount it can borrow in capital markets. Pressure from the German public, however, might prevent the Bundesbank from reaching the theoretical limit. There are several political thresholds. The first is when the stock of Bunds in the Bundesbank hits zero. As Table 2 shows, this threshold has been reached. Even before the 2008 crisis the stock of Bunds in the Bundesbank was practically zero. The second threshold will be reached when the stock of loans from the Bundesbank to the private sector is depleted. As we described above, the stock of loans to private credit institutions has fallen to almost zero. At the end of October 2011, it stood at €21 billion.

Next, the Bundesbank could sell its gold (currently €132 billion) or its international reserves (of €49.5 billion). However, it has fiercely refused to do so in a heated debate with other Eurozone members last October. Instead of drawing down its holdings of gold, the Bundesbank became a net debtor in the private domestic capital market, as shown in Figure 3.

Table 2. The Bundesbank balance sheet

Assets

2006

2007

2008

2009

2010

Oct 2011

Total

373

483

612

588

629

773

Gold

53

62

68

84

115

132

Reserves

31

37

94

42

47

50

Private securities owned by central bank

256

268

277

224

83

21

Public securities owned by central bank

4

4

4

4

4

4

Other assets

3

13

22

20

46

70

Eurosystem claims (TARGET)

25

98

146

210

356

496

Liabilities

2006

2007

2008

2009

2010

Oct 2011

Total

373

483

612

588

629

773

Bills in circulation

255

283

327

348

366

385

Deposits from private credit institutions

48

109

166

112

146

212

Other liabilities

64

83

90

114

151

168

Capital

5

5

5

5

5

5

Source: Monthly bulletins of the Bundesbank, various issues.

Note: Bills in circulation are constructed by assigning 8% of the total Bills uniformly across member countries. The remaining 92% are assigned using the capital share of each country.

Figure 3. The Bundesbank has become a net borrower of private credit institutions

Source: Bundesbank, Monthly Bulletins.

The mechanism

As we have described, in the European monetary union, the stock of securities held by a central bank can increase in a member country even though the ECB might not pursue an expansionary policy for the Eurozone as a whole. This creation of base money is not done via the printing press as in old times, but electronically. To illustrate the mechanism consider the following example. An owner of Greek government bonds uses them as collateral to borrow from his commercial bank, which in turn borrows from the Bank of Greece. The Greek central bank wires the funds via the ECB to the Bundesbank, which in turn deposits them in the Frankfurt bank account of the Greek resident. As a consequence, the Bundesbank gets a ‘TARGET claim’ on the ECB and the Bank of Greece gets a ‘TARGET liability’ at the ECB. This TARGET claim is secured by collateral – the Greek government bonds – deposited at the ECB that were previously in the possession of the Greek resident. Through this operation, the increase in the stock of securities at the Bank of Greece is matched by a reduction of securities in the Bundesbanks’ balance sheet. The Bundesbank sells some of its assets to be able to deposit the funds into the Greek residents’ private Frankfurt bank account. As a result, German assets are replaced by ECB collateral (TARGET claims) in the balance sheet of the Bundesbank. The aggregate Eurozone monetary base, however, is unaffected in this example (see Garber 1998, Sinn and Wollmershäuser 2011, and Buiter et al 2011).

Figure 4 shows the dramatic increase in loans from the German Bundesbank and the Dutch central bank to the Eurosystem. From 2007 to September 2011, the TARGET liabilities of the GIIPS at the ECB have increased by €329 billion, while the TARGET claims of Germany at the ECB have increased by €404 billion and those of the Netherlands by €75 billion. These numbers are extraordinarily large. The TARGET liabilities of the GIIPS amount to 63% of total stock of securities held by central banks in these countries.

A comparison of Figures 2, 3, and 4 reveals that over the period from 2007 to the third quarter of 2011 the increase of the Bundesbank’s TARGET claims at the ECB tracks its reduction in loans to the private sector plus the increase in deposits it takes from credit institutions.

What are the limits of this mechanism?

In principle the sky is the limit. De facto, however, this monetary process may face a political limit. We have described the limits that the Bundesbank faces. Next, we consider the perspective of the GIIPS and the ECB.

Figure 4. Claims on the Eurosystem (up to September 2011)

Source: IFS and Bundesbank Monthly Bulletin, November 2011.

Note: Claims on the Eurosystem are taken from the central bank survey of the IFS, except Germany. For Germany, the series displays the cumulative outflows via the central bank, that are recorded under “monetary authorities – other items” in the “Balance of payments statistics” of the IFS. The value for 2011-Q3, is taken from the November issue of the monthly bulletin of the Bundesbank.

How long can the central banks of the GIIPS accumulate TARGET liabilities at the ECB? In theory, as long as they have collateral that is acceptable to the ECB, which is the total stock of government debt plus other marketable assets (such as mortgage-backed securities) recognised by the ECB. However, running out of collateral won’t necessarily stop the borrowing. Should central banks run out of government bonds, the national governments could issue more bonds, and sell them to private banks. Banks in turn could use them as collateral to borrow from their central banks. Thus, practically, there is no limit to the amount of domestic government bonds the national central banks could use as collateral to accumulate TARGET claims at the ECB.

Next, consider the perspective of the ECB. As long as the ECB accepts government bonds and other marketable assets as collateral, the expansionary policy in the periphery can continue. Another possibility is that in order to prevent a national central bank from excessive expansion of loans to financial institutions, the ECB could stop accepting that country’s bonds as collateral. Should the ECB cease accepting collateral from one of its member countries, that country would effectively be excluded from the Euro TARGET transfer system. Such a country, however, could still use the euro as its official currency.

Policy actions

Up to now, Bundesbank loans have allowed GIIPS central banks to buy government bonds without a corresponding increase in the monetary base of the Eurozone as a whole – ie, without the ECB printing more money (after an expansion in 2008, the monetary base returned to trend growth). Before long, however, the Bundesbank’s stock of domestic assets is going to hit zero, and it is highly unlikely that it will agree to sell its gold or borrow more in private capital markets. At that point, the Bundesbank will not be able to lend more funds to the Eurozone TARGET mechanism. As a result we are heading towards the multiple equilibria zone in which beliefs of a breakdown of the Eurozone are self-fulfilling. In such a situation, market participants may transfer funds from financial institutions in fiscally weak countries to other ‘safe’ countries like Germany. In tranquil times, such transfers can be done seamlessly through the TARGET mechanism of the ECB. However, if a critical mass of agents were to engage in such capital flight away from fiscally weak countries, the TARGET system would be overwhelmed. In principle, a speculative attack could occur within a day, and the ECB would have to assume all of the marketable securities from countries that suffer the speculative attack. Since the ECB has a relatively small capital base, it would not be able to purchase a large amount of assets from countries that suffer the attack.

In Act Two of the unfolding Eurozone drama, the new measures might include the ECB printing more money, the EU announcing the issuance of Eurobonds, or the IMF extending credit lines to strapped governments. The motive of such a policy response is to prevent a speculative attack and induce a shift to the good equilibrium. These actions will buy some time for economic and fiscal reforms to take place. However, as previous experiences suggest, if reforms do not take place, these measures may be very costly to the taxpayer (see Sachs et al 1996).